Redress of EIS abuse is necessary – but so is stimulating SME growth

News that the Enterprise Investment Scheme (EIS) is to be reformed in the Budget is welcome, despite protestations from some in the SME investment industry.

It’s true that EIS has done much to encourage early stage business investment – last year almost 3,300 companies benefitted with £1.6bn in funds raised. However, the time has come to take a critical look at how EIS is working, and to make sure it is being used to fund proper trading businesses whose growth will create jobs and wealth.

More importantly, in my view, policymakers should also take the opportunity to promote tax breaks which support small and medium-sized business (SME) growth at all stages.

Concerns that radical changes to EIS will lead to a sharp slowdown in early stage business investment may well be realised in the short term. That doesn’t mean that reform of the system isn’t necessary.

Companies sometimes view EIS as an easy way to secure funding without any real commitment to driving the business forward, while some investors simply see it as a way of minimising their tax bills, rather than focussing on the merit of the underlying investment.

Reforms are likely to target less risky “asset-backed” businesses and “artificial structures” (whose purpose is to obtain tax relief rather than support genuine trading growth) using the system.

Another issue is where companies raise money without clear ambition for, or likelihood of, success, knowing that EIS will give investors tax relief if they close down – something it is now easier to do with the rise of crowdfunding.

EIS was never intended to encourage such behaviour: it should be providing tax breaks to investors who are genuinely taking risks with their capital to help ambitious businesses grow.

But why stop at startups and early stage businesses? If the government wants to help drive economic growth, job creation and innovation, it should focus tax breaks on SMEs at all stages of their evolution.

I fear there is currently an obsession with ensuring the next Google or Facebook is a UK business, but it is larger, more-established businesses that tend to be the engines of employment and tax receipts.

Some easy steps could redress the balance. One is to rethink the seven-year EIS rule – a relatively recent introduction – which restricts EIS-eligibility to businesses that are seven years old or less (except in very limited cases).

Another is to do more to promote and clarify the benefits of Entrepreneur’s Relief, which was recently extended to include long term investors in unlisted companies, reducing their capital gains tax rate.

Currently, lack of awareness and confusion around eligibility are limiting its usefulness as a tool to help encourage investment.

Entrepreneurs’ Relief also makes more sense from a cost/benefit point of view as far as the Treasury is concerned, because tax relief is given only once value has been created, rather than at the outset, no matter what the outcome – as with EIS.

Such measures should also benefit investors with a lower risk appetite, for whom investments in startups and early stage businesses, which tend to have a higher failure rate, are not suitable.

EIS is meant to help mitigate the risk of small business investing, but there are clear signs the scheme is not working as it should. It’s right that its effectiveness is reviewed. But EIS is just part of the issue. A wider focus for enterprise investment tax breaks to support SME growth across the board is what will really power UK Plc going forward.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.